The Role of a Lease in Enclosed Mall Shopping Center Development

TASA ID: 718

Many developers see lawyers as a needlessly expensive element of the cost of development. Moreover, they see leases, reciprocal easement agreements and other shopping center contracts as a boring string of highfalutin words. 

Actually, all shopping centers in general and enclosed mall shopping centers in particular can be said to have been built on a foundation of paperwork as much as they are built on a foundation of reinforced concrete. Although a shopping center building is usually composed principally of steel and masonry, no shopping center could be constructed, financed, bought or sold without creating a pile of contracts, leases and mortgages.

Of all the legal instruments on which a shopping center development is based, the lease between the shopping center developer and the operators of the stores is the most important.

I. Why Are Store Leases So Important?

A. Store leases create an income stream to reward the developer and his mortgage lenders for their investments.

B. Store leases govern the types of products that may be sold in the shopping center and the kinds of services that may be rendered in the shopping center.

C. Store leases provide rules for the housekeeping chores of the landlord and the tenant.

II. The Income Stream

A. Application of the Income Stream

The rent clauses of a shopping center store lease provide the legal basis for the landlord's right to be paid by his tenants for the privilege of occupying space in the shopping center. However, the landlord doesn't usually keep all or even most of the rent. Shopping centers are usually financed by long-term loans provided by financial institutions. A large portion of the tenants' rent payments is applied to repay these loans. Of course, the balance is retained by the landlord. The balance retained by the landlord is also important to the institutional lender. It serves as a cushion to help make the lender feel comfortable that the landlord-borrower has an equity worth fighting for and that he won't abandon the property. Consequently, the rent clauses of a shopping center lease make it possible for the shopping center to be built and financed in the first place.

B. Types of Shopping Center Rent

Rental clauses of a shopping center lease are very complicated. Of course, shopping center tenants expect to pay a fixed monthly rent, but the fixed monthly rent is only a part of a larger package of rent payments. The larger package of rent payments also includes rent intended to be applied to discharge the expenses of operating and maintaining the shopping center; rent intended to protect the landlord against inflation; and rent intended to provide a bonanza for the landlord in case the shopping center turns out to be an extremely successful economic unit.

C. The Minimum Rent

When landlords and tenants negotiate rent, their principal focus is on minimum rent. Three basic issues dominate the minds of minimum rent negotiators: the landlord's need for a rent roll that will, at least, discharge the mortgage loan payments and provide some extra income for the landlord; the market rate for rent for the type of shopping center involved; and the potential of each tenant for sales achievement. 

When rental rates are negotiated, large department store chains have a significant edge. The tenant mix of almost all enclosed shopping centers is based on deals with large department store tenants. The department stores serve as magnets to attract customers and smaller tenants. To convince large department stores to locate in a new shopping center being developed, an enclosed mall developer might well agree to rental rates that fall far below fair compensation for the cost of land and building. 

Another group of tenants, chain small store operators, are willing to pay much more rent but still not enough to generate significant profits for the landlord.

Consequently, an enclosed mall developer has considerable pressure to demand very high rents from local small store tenants we call the "mom and pops." In fact, the bulk of many enclosed mall developers' profits stem from mom and pop.

As a result of these factors, it would not be out of the question to review the leases for an enclosed mall shopping center and discover that the moms and pops are paying more than four times as much rent as the department store tenants.

Even small store tenants have a better bargaining position when they negotiate a lease before a shopping center is constructed. If a shopping center proves to be successful after it's built and leased, tenants will stand in line and bid up the price of the space.

The annual rate of minimum rent need not be a fixed amount throughout the entire term of the lease. The parties might agree on a sliding scale that will permit a tenant to get started at a cheaper rent during the earlier years of the lease and compensate the landlord by paying a higher minimum rent as time goes on.

D. Rent Intended to Compensate the Landlord for Operating and Other Expenses

Since 1960, I've seen many variations of rent deals. I've seen "gross leases" pursuant to which the tenant agrees to pay fixed minimum rent and percentage rent but nothing more. Conversely, I've seen net lease deals that are structured so that the tenant pays all of the expenses of operation and management in addition to fixed minimum rent and percentage rent. Moreover, I've seen all kinds of variations between the two extremes.

The net lease is a more popular vehicle in today's market than it was in the early days of the shopping center era. A net lease tenant not only bears its pro rata share of all operating expenses of the shopping center, but it also bears its pro rata share of all capital expenditures and all risks of ownership, management and operation. Most enclosed mall store leases I see today are structured on a variation of the net lease theme. The underlying theme of the net lease is a series of clauses that require the tenant to fully compensate the landlord for the tenant's pro rata share of taxes and other governmental charges imposed against the shopping center, common area maintenance charges incurred by the landlord, the landlord's cost of carrying insurance, and the cost of utilities.

Landlords and tenants should be very careful when they negotiate clauses that provide that the tenant is required to reimburse the landlord for a share of taxes and other governmental charges. 

Carelessly drafted definitions could greatly increase or decrease the amount the tenant is required to pay as its share of taxes and other governmental charges.

What are taxes and other governmental charges? Do they include betterment assessments? Do they include taxes on rent and other possible taxes levied as substitutes for existing real estate taxes? When does the tenant start reimbursing the landlord for taxes and other governmental charges? Should payments be made as the shopping center is being constructed or should they wait until the construction is finished?

How do you figure the tenant's pro rata share of taxes and other governmental charges? If the landlord is sloppy in defining the amount of the tenant's pro rata share, he might discover that, when all of the pro rata shares are added together, they equal something less than 100%. If they do, the landlord will be required to bear a part of the taxes and other governmental charges, and the tenants will get a bargain. On the other hand, it's possible for the landlord to manipulate the percentages that constitute pro rata share to his advantage. If he does, the tenants might be faced with the absurdity of increasing their rent by $1.50 every time the taxes go up by $1.00.

E. Rent Intended for Inflation Protection

Many shopping center leases have long terms. Twenty years is not an unusually long period, and many shopping center leases with which I'm familiar have terms that exceed forty years.

Some landlords are hypersensitive about the possibility of inflation. These landlords and many others insist that the tenant agree to pay rent supplements to compensate the landlord for any increases in the cost of living.

Rent supplements are usually based on one of the consumer price indexes issued by the Bureau of Labor Statistics. One popular pattern is to require a rent supplement based on increases in a consumer price index every time the term of the lease is extended. Other leases require the tenant to pay a cost of living increase during the initial term of the lease as well.

F. Rent as a Share of Prosperity

Almost all shopping center tenants agree to pay additional rent to the landlord if their sales volume exceeds a predetermined base.

Sometimes, this form of rent, called percentage rent, is defined as a percentage of the amount by which the tenant's gross sales exceeds a fixed sales base (e.g., $2 million). Other leases define percentage rent as the amount by which a given percentage of the tenant's gross sales exceeds the minimum rent and some or all of the other charges the tenant is required to pay to the landlord.

The exact method of defining percentage rent can result in big changes in the amount of money the tenant is required to pay as percentage rent. Here's an example. Suppose these facts.

1. Minimum rent is $50,000.

2. Gross sales are $900,000.

3. The lease year begins on February 1 and ends on January 31.

4. The demised premises are destroyed by fire on July 31.

5. Minimum rent abates for the balance of the lease year.

If percentage rent is defined as 5% of the amount by which gross sales exceed $1,000,000, the tenant would not be obliged to pay any percentage rent at all. That doesn't seem fair. The store is obviously a winner, and the landlord ends up with nothing special to reward his selection of good location. On the other hand, if percentage rent were defined as the amount by which 5% of gross sales exceeds minimum rent payable during the lease year, the landlord would be entitled to percentage rent of $20,000. (Five % of gross sales would be $45,000, and the minimum rent would be only $25,000 for the part of the lease year in which minimum rent did not abate.)

Percentage rent is viewed as a bonanza to landlords nowadays. However, it didn't start that way. In fact, percentage rent was originally used as a technique by chain store tenants to try to keep their rent down. In the depression era, chains such as W. T. Grant Company leased variety stores in downtown business districts all over America on the basis of percentage rent. They offered no minimum rent at all. Their concept of the value of a store was that it was worth 1% of the aggregate sales price of the merchandise they could sell there. 

II. Types of Products to Be Sold and the Kinds of Services to Be Rendered

A. Importance of Tenant Mix

Enclosed mall shopping centers are much more than haphazard arrangements of merchants willing to pay rent. Customers are drawn to an enclosed mall shopping center by the prospect of being able to choose from a wide variety of merchandise and a wide variety of marketing styles.

Obviously, enclosed mall shopping center customers like to browse and to compare merchandise. Perhaps even more, they like to compare prices and look for bargains. Of course, this kind of activity would be inhibited if the customer would find too many stores that sold the same kind of merchandise in the same old way. Not being able to find something you're looking for is also an inhibiting factor. If you're looking for a book, greeting card, or ceramic vase at a shopping center and you can't find one, you may not be in a big hurry to return.

B. Avoiding Competition

Another important factor that influences tenant mix is that merchants are not overly fond of direct competition. Many of them prefer to join shopping centers where there isn't much or, even better, where there isn't any.

C. Function of Use and Exclusive Clauses

The use clause and the exclusive clause of a shopping center lease are the clauses that regulate the type of merchandise that may be sold and the types of services that may be rendered from each store.

The landlord pushes the use clause. That's the clause that restricts the kinds of merchandise to be sold and services to be rendered in the tenant's store.

Tenants are fond of exclusive clauses. These clauses restrict the kinds of merchandise that can sold in other stores.

D. Coping with Use and Exclusive Clauses

It's quite a challenge to deal with use and exclusive clauses.

If any tenant is granted an exclusive, the landlord must be very careful to make sure that he actually prohibits every other tenant from selling the excluded merchandise or rendering the excluded service.

Use and exclusive clauses of the first few leases of a shopping center are particularly difficult to negotiate. The landlord usually faces off with the most powerful tenants first. They demand the right to sell broad ranges of merchandise and don't want to be restricted. The landlord might be tempted to agree to a broad range of exclusives merely to get a big tenant to sign a lease. However, he's forced to be careful and to anticipate the possibility that he might lose a valuable tenant in the future because of a use clause that's too restrictive.

The whole process is too broad and is further complicated by the limitations imposed by federal and state antitrust laws. Some shopping center lease restrictions, particularly those that attempt to limit the prices or price ranges of merchandise and services, may violate the antitrust laws.

III. Housekeeping Chores Governed by Shopping Center Leases

A. Repairs

Suppose a store manager discovers that one of the store's lighting ballasts is broken. Should he hire an electrician, or can he expect the landlord to come and repair or replace the ballast? The "repair" clause of most enclosed mall shopping center leases would require the tenant to replace the ballast and almost all other interior elements of the store (with some exceptions). On the other hand, the landlord is usually expected to keep the parking lot and the enclosed common walkways in good order and repair.

Actually, in addition to the "repair" clause, shopping center leases contain quite a few clauses that deal with the question of repair. The compliance with laws, surrender, and destruction clauses really deal mostly with repairs. The main issue discussed by a compliance with laws clause is who is required to comply with legal requirements relating to the state of repair in which a building is kept. If a building is allowed to deteriorate, a governmental agency might issue an order that it be repaired. The compliance clause will tell you whether the landlord or the tenant is required to comply with this order.

The surrender clause usually provides that the demised premises are to be surrendered at the end of the term in good order and repair (except for reasonable wear and tear). Here too, the lease requires repairs to be made.

The destruction clause also obliges either the landlord or tenant to repair damage caused by fire or other catastrophe.

It's smart to combine all of these ideas into one clause. It will make the lease shorter and easier to understand.

B. Alterations and signs

The appearance of store fronts and exterior signs are of paramount importance to an enclosed mall landlord and the tenant alike.

Ideally, an enclosed mall shopping center should be an architectural gem, and the design of its stores should be governed by an intelligent set of architectural principles.

Early shopping center developers didn't care much about what the storefronts looked like and cared even less about the exterior signs. What was of paramount interest was rent, and what was of secondary interest was rent.

Shopping center developers are still interested in rent, and that should come as no surprise. What's changed, however, is that they've learned that unless the shopping center looks good to customers, customers won't come and shop. Moreover, if customers won't come and shop, the stores won't do enough business to pay rent. Accordingly, the current interest of shopping center developers in the aesthetics of store fronts and signs is very practical indeed.

Alterations clauses limit the tenant's right to change the appearance of its store front. (They also restrict the tenant's right to change other parts of its premises). Sign clauses limit the design and content of store signs and the panels on which store signs are displayed.

Landlords have a need to make these clauses more restrictive, and tenants have a need to make them less restrictive.

Overly restrictive alterations and use clauses can make life difficult for the tenant. If a tenant is unable to make alterations to its premises, it won't be in a position to change the way it operates its store and to change the types of merchandise it sells there. Sign restrictions are also impediments to a change of a tenant's merchandising effort.

Both alterations and sign clauses could make it impossible for a tenant to sell its store business. Assuming that the lease permits assignment of a tenant's leasehold estate, the tenant would have a hard time finding someone to buy its business if the premises could not be altered to meet the needs of the assignee, and the sign could not reflect the business name of the assignee. 

IV. Actually Reading Leases

Of course, leases deal with many other issues, and they can be long documents that are very difficult to read. If you haven't read a lease yet and aren't looking forward to your first encounter, please be reassured. I dreaded the prospect of reading my first lease, and the actual reading was still more unpleasant than the anticipation.

Until you get used to this stuff, it's hard to cope with the long and ungrammatical sentences, the disorganized pattern of the clauses, the repetition, and the laborious definitions. However, after doing this for approximately ten hours a day for twenty-five years, it not only becomes easy--it becomes fun.

What's the matter; you don't believe me?

 This article discusses issues of general interest and does not give any specific legal or business advice pertaining to any specific circumstances.  Before acting upon any of its information, you should obtain appropriate advice from a lawyer or other qualified professional.  

This article may not be duplicated, altered, distributed, saved, incorporated into another document or website, or otherwise modified without the permission of TASA.